What Is IFRS 16 and How Does It Impact Lease Accounting?

IFRS 16 is an international accounting standard issued by the International Accounting Standards Board (IASB) that provides a model for lease accounting. It replaced the previous standard, IAS 17, to enhance the transparency and comparability of financial reporting. This standard became effective for annual reporting periods beginning on or after January 1, 2019. The objective of IFRS 16 is to ensure that financial statements faithfully represent lease transactions, allowing users to better assess the amount, timing, and uncertainty of cash flows arising from leases.

Identifying a Lease

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition is central to IFRS 16, requiring entities to scrutinize contracts that might not explicitly be labeled as leases but involve the use of a specific asset. The assessment hinges on two key criteria: the presence of an “identified asset” and the customer’s “right to control the use” of that asset.

An asset is identified if specified in the contract or implicitly made available for use. However, if the supplier has a substantive right to substitute the asset, the customer does not have the right to use an identified asset. For instance, a contract for a specific machine with a unique serial number typically involves an identified asset. Conversely, a contract for “any available machine from a fleet” might not, if the supplier can easily substitute the asset and benefits economically from doing so.

The right to control the use means the customer has the right to obtain substantially all economic benefits from the asset’s use and to direct its use. For example, if a company leases a specific truck and determines its routes, cargo, and operating hours, it likely controls the use of that truck. Conversely, if a shipping company provides transportation services using its own trucks and determines all operational aspects, the customer does not control the truck’s use, even if the service is for the customer’s goods.

Lessee Accounting Fundamentals

For lessees, IFRS 16 fundamentally changed how leases are recognized, moving most leases onto the balance sheet. This “on-balance sheet” model requires lessees to recognize a “right-of-use” (ROU) asset and a corresponding “lease liability” at the commencement date of the lease. This approach applies to nearly all leases with a term exceeding 12 months, unless specific exemptions are chosen.

The initial measurement of the lease liability involves discounting future lease payments to their present value. These payments generally include fixed payments, variable payments, residual value guarantees, and the exercise price of a purchase option if reasonably certain. The discount rate used is typically the interest rate implicit in the lease; if not readily determined, the lessee’s incremental borrowing rate is used. For example, if a company leases equipment with annual payments of $10,000 for five years, these payments are discounted to their present value to determine the initial lease liability.

The ROU asset is initially measured at cost, including the initial lease liability. It also incorporates any lease payments made at or before the commencement date, less any lease incentives received, and initial direct costs incurred by the lessee. For instance, if the present value of lease payments is $45,000, initial direct costs are $1,000, and a prepayment of $5,000 was made, the ROU asset would initially be $51,000.

After initial recognition, the ROU asset is subsequently measured at cost less accumulated depreciation and any accumulated impairment losses. It is generally depreciated over the shorter of the lease term or the useful life of the underlying asset, typically on a straight-line basis. The lease liability is subsequently measured using the effective interest method, where the carrying amount increases to reflect interest expense and decreases for lease payments made.

The impact on financial statements for lessees is significant. In the income statement, a single lease expense is replaced by two separate expenses: depreciation of the ROU asset and interest expense on the lease liability. This typically results in higher total expenses in the early years of a lease and a declining expense over the lease term. On the cash flow statement, principal payments on the lease liability are presented as financing activities, while interest payments can be classified as either operating or financing activities, depending on the entity’s accounting policy choice.

Accounting Exemptions and Simplifications

IFRS 16 offers practical expedients that allow lessees to avoid the full on-balance sheet accounting model for certain types of leases. These exemptions aim to reduce the administrative burden for contracts that are less material or short-lived. When these exemptions are applied, lease payments are recognized as an expense on a straight-line basis over the lease term, similar to how operating leases were treated under the previous accounting standard.

One exemption is for short-term leases, defined as leases with a lease term of 12 months or less at the commencement date and containing no purchase option. This election is made by class of underlying asset, meaning if a company chooses this exemption for its office equipment leases, it must apply it to all such leases. For example, a six-month rental of a copier would qualify for this exemption.

Another exemption applies to leases of low-value assets. While IFRS 16 does not specify a monetary threshold, common practice suggests assets that are valued at approximately $5,000 or less when new often qualify, such as personal computers, small items of office furniture, or telephones. This election can be made on a lease-by-lease basis. The assessment of low value is based on the value of the asset when new, regardless of the lessee’s size or circumstances.

Additional practical expedients can simplify the application of IFRS 16, such as the option to not separate lease and non-lease components in a contract. For instance, if a contract includes both the lease of equipment and maintenance services, a lessee can elect to account for both as a single lease component, provided certain criteria are met. These simplifications help streamline the accounting process, particularly for entities with a large volume of similar contracts.

Lessor Accounting and Reporting Requirements

Lessor accounting under IFRS 16 largely remains consistent with the principles from the previous standard, IAS 17. Lessors continue to classify leases as either “finance leases” or “operating leases”. This classification determines the accounting treatment and how the lease is reflected on the lessor’s financial statements.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee. Indicators of a finance lease include the transfer of ownership to the lessee by the end of the lease term, a purchase option that is reasonably certain to be exercised, or a lease term covering the major part of the asset’s economic life. For finance leases, the lessor derecognizes the leased asset and recognizes a net investment in the lease, which is essentially a receivable. Interest income is then recognized over the lease term.

Conversely, an operating lease does not transfer substantially all the risks and rewards of ownership to the lessee. For operating leases, the lessor retains the underlying asset on its balance sheet and recognizes lease income, typically on a straight-line basis over the lease term. The asset continues to be depreciated by the lessor.

IFRS 16 enhances disclosure requirements for both lessees and lessors to provide users with comprehensive information about leasing activities. Lessees must disclose qualitative and quantitative information, including general descriptions of their leasing activities, significant judgments, and a maturity analysis of lease liabilities. Quantitative disclosures also include ROU asset carrying amounts by class, expenses for short-term and low-value leases, and total cash outflows for leases.

Lessors also have specific disclosure objectives, emphasizing information about the nature of their leasing activities and how they manage risks associated with retained rights in leased assets. These disclosures aim to give financial statement users a clear picture of the impact of leases on an entity’s financial position, performance, and cash flows.